This is in fact not a measure of liquidity at all. It is merely grahping the total return of short term markets. The reason why it used the term "liquid" in this case is b/c it is looking at securities inside of 12 mos to maturity (think m1-m3 types of instruments) and thus represents the more "liquid" or cash equivalent securities of the market. Do not confuse this with "liquidity" which this graph does not measure. Liquidity measures try to show the ability to trade positions freely. Lastly, the only reason why this number has shrunk recently is that shorter term securities are yielding virtually nothing these days (take a look at your bank acct), and as another poster mentioned already, market assets are slowly trickling back into riskier asset classes (ie equities). A better indication of liquidity in the overall market would be measures such as the TED spread.

Dude, that's garbage - you KNOW the TED spread is doctored beyond measure by the pariticpating banks and the working group. The only real measure from a credit point of view is the LIBOR-OIS spread, and even that is not immune to LIBOR shifts. Regardless, the latter is hardly painting the rosy picture the TED does.